Financial Liberalization, Debt Mismatch, Allocative Efficiency and Growth

American Economic Journal: Macroeconomics, 2015

Financial liberalization increases growth, but leads to more crises and costly bailouts. We present a two-sector model in which liberalization, by allowing debt-denomination mismatch, relaxes borrowing limits in the financially constrained sector, but endogenously generates crisis-risk. When regulation restricts external financing to standard debt, liberalization preserves financial discipline and may increase allocative-efficiency, growth and consumption possibilities. By contrast, under unfettered liberalization that also allows uncollateralized option-like liabilities, discipline breaks down, and efficiency falls. The model yields a testable gains-from-liberalization condition, which holds in emerging markets. It also helps rationalize the contrasting experience of emerging markets and the recent US housing-crisis.


Was the U.S. Crisis a Financial Black-Hole?

IMF Economic Review, 2012

This paper argues that the U.S. financial crisis is a new type of crisis: a “financial black hole.” Financial black-holes are characterized by the breaking-up of credit market discipline and the large-scale financing of negative net present value projects. In a theoretical model, the paper explains how the interaction of perceived government guarantees and the ability to issue catastrophe-bond-like liabilities generates financial black-holes. The paper then shows that key facts of the recent U.S. crisis can simultaneously be rationalized by the financial black hole equilibrium: Between 2003 and 2006, the origination of catastrophe-loan type mortgages exploded, as well as the issuance of ‘Private Label’ mortgage backed securities that helped off-load them into the market. During the same period, there was a massive increase in the origination of mortgages to borrowers with limited repayment ability, absent a continuous increase in home prices. While this situation should have led to an upward repricing of the risk associated with Private Label MBS, the contrary occurred and the spread on these securities actually declined. While each of these facts in isolation can be interpreted differently, the strength of the financial black-hole explanation is its ability to account for the combination of these key facts.


Currency Mismatch, Systemic Risk in Emerging Europe

Economic Policy, 2010

Currency mismatch is a vehicle that exposes the economy to systemic risk, but it is also an engine of growth. We analyse this dual role at the macro and the micro levels. At the aggregate level, we construct a new measure of currency mismatch in the banking sector that controls for bank lending to unhedged borrowers -– that is, those with no foreign currency income. Using our measure, we find that across emerging European economies, increases in currency mismatch are associated with higher growth in tranquil times, but also with more severe crises. On net, after taking into account the crisis period, we find a positive link between currency mismatch and growth. These results are also confirmed for a broader sample of emerging economies. In our firm-level analysis, we find that in emerging Europe, currency mismatch relaxes borrowing constraints, reduces
interest rates and enhances growth across sets of firms that arguably are the most credit constrained – that is, small firms in non-tradables sectors – but not across large firms. An advantage of our approach is that it considers both listed and non-listed firms, and so we are able to effectively capture the effects of currency mismatch across the entire economy, not just the financially privileged stock market listed firms.


Financial Liberalization

The New Palgrave, 2008

Financial liberalization has led to financial deepening and higher growth in several countries. However, it has also led to a greater incidence of financial crises. Here, we review the empirical evidence on these dual effects of financial liberalization across different groups of countries. We then present a conceptual framework that explains why there is a trade-off between growth and incidence of crisis, and helps account for the cross-country difference in the effects of financial liberalization.


Systemic Crises and Growth

Quarterly Journal of Economics, 2008

Countries that have experienced occasional financial crises have, on average, grown faster than countries with stable financial conditions. Because financial crises are realizations of downside risk, we measure their incidence by the skewness of credit growth. Unlike variance, negative skewness isolates the impact of the large, infrequent, and abrupt credit busts associated with crises. We find a robust negative link between skewness and GDP growth in a large sample of countries over 1960–2000. This suggests a positive effect of systemic risk on growth. To explain this finding, we present a model in which contract enforceability problems generate borrowing constraints and impede growth. In financially liberalized economies with moderate contract enforceability, systemic risk taking is encouraged and increases investment. This leads to higher mean growth but also to greater incidence of crises. In the data, the link between skewness and growth is indeed strongest in such economies.


Unpublished Appendix to Systemic Crises and Growth


Decomposing the Effects of Financial Liberalization: Crises vs. Growth, Journal of Banking and Finance

Journal of Banking and Finance, 2006

We present a new empirical decomposition of the effects of financial liberalization on economic growth and on the incidence of crises. Our empirical estimates show that the direct effect of financial liberalization on growth by far outweighs the indirect effect via a higher propensity to crisis. We also discuss several models of financial liberalization and growth whose predictions are consistent with our empirical findings.


Balance Sheet Effects, Bailout Guarantees and Financial Crises

Review of Economic Studies, 2004

This paper provides a model of boom–bust episodes in middle-income countries. It is based on sectoral differences in corporate finance: the nontradables sector is special in that it faces a contract enforceability problem and enjoys bailout guarantees. As a result, currency mismatch and borrowing constraints arise endogenously in that sector. This sectoral asymmetry allows the model to replicate the main features of observed boom–bust episodes. In particular, episodes begin with a lending boom and a real appreciation, peak in a self-fulfilling crisis during which a real depreciation coincides with widespread bankruptcies, and end in a recession and credit crunch. The nontradables sector accounts for most of the volatility in output and credit. 


Liberalization, Growth, and Financial Crises: Lessons from Mexico and the Developing World

Brookings Papers on Economic Activities, 2003

Boom-Bust Cycles in Middle Income Countries : Facts and Explanation

IMF Staff Papers, 2002

In this paper we characterize empirically the comovements of macro variables typically observed in middle income countries, as well as the ‘boom-bust cycle’ that has been observed during the last two decades. We find that many countries that have liberalized their financial markets, have witnessed the development of lending booms. Most of the time the boom gradually decelerates. But sometimes the boom ends in twin currency and banking crises, and is followed by a protracted credit crunch that outlives a short-lived recession. We also find that during lending booms there is a real appreciation and the nontradables (N) sector grows faster than the tradables (T) sector. Meanwhile, the opposite is true in the aftermath of crisis. We argue that these comovements are generated by the interaction of two characteristics of financing typical of middle income countries: risky currency mismatch and asymmetric financing opportunities across the N- and T-sectors.


Lending Booms and Currency Crises: the Empirical Link

Regional Global Capital Flows: Macroeconomic Causes and Consequences. The University of Chicago Press, 2001


Privatizing the Privatized

The Second Round of Reforms. The University of Chicago Press, 2001

The Mexican Peso Crisis: Sudden Death or Death Foretold

Journal of International Economics, 1996

We argue that allowing for the possibility of a self-fulfilling panic helps to understand several features of the recent Mexican crisis. Self-fulfilling expectations became decisive in generating a panic only after the government ran down gross reserves and ran up short-term dollar debt. We present a simple model to explain how and why multiple equilibria can occur for some levels of reserves or debt, but not for others. Lastly, we argue that the imperfect credibility of Mexican exchange rate policy made it advisable to follow more contractionary fiscal and monetary policies in 1994. Our model formalizes the reasons why this is so.  


Financial Crises in Emerging Markets: The Lessons From 1995

Brookings Papers on Economic Activity, 1996


The Collapse of the Mexican Peso: What have we Learned?

Economic Policy, 1996

In the first quarter of 1995, Mexico found itself in the grip of an intense financial panic. Foreign investors fled the country despite very high interest rates, an undervalued currency and financial indicators that pointed to long-term solvency. The fundamental conditions of the Mexican economy cannot account for the extent of the crisis. The crisis was not the result of irresponsible fiscal behaviour. The crisis was due to unexpected shocks that occurred in 1994, the inadequate policy response to those shocks, the increased vulnerability to panic, and finally panic itself. In the aftermath of the March assassination, the exchange rate experienced a nominal devaluation of around 10% and interest rates increased by 7 percentage points. However, capital outflows continued. The policy response was to maintain the exchange rate rule and to prevent further increases in interest rates. Interest rates were held down by expanding domestic credit and by converting short-term pesodenominated government liabilities (Cetes) falling due into dollardenominated bonds (Tesobonos). A fall in international reserves and an increase in short-term dollar-denominated debt resulted. The government simply ended up illiquid, and therefore financially vulnerable. Illiquidity exposed Mexico to a self-fulfilling panic.